Despite ongoing disintermediation in the European direct-lending market, strong origination agreements with banks continue to be vital to access high-quality loans – particularly in the mid-market space. Here we explain why.

The European small- and medium-sized enterprise (SME) lending market has traditionally been the preserve of the banks: they have vast networks and strong relationships for originating deals in this sector. The SME funding landscape, however, changed dramatically in the wake of the global financial crisis amid growing regulatory pressure – and investment firms filled a gap left by European banks to provide SME financing.

Today, the market is disintermediating gradually in Europe, but banks still claim the lion’s share of financing for mid-market companies and they tend to be the biggest lenders in their home markets. What’s more, some which exited the market are now re-entering, regaining market share as their balance sheets have improved since the financial crisis. That means companies still source all or part of their financing from banks, as banks have fostered long-term relationships in specific regions where these companies are located, making it difficult for direct lenders to independently generate pipelines of high-quality loans.

Nevertheless, there is an increasing opportunity for direct lenders in Europe: funds based on the continent that run direct lending strategies raised more than €20bn in 2017, up from €9bn the previous year1. Direct lending now accounts for 10% of Europe’s business loan market2.

A fragmented market

Given the prominent role of banks in business lending, direct lenders seeking attractive SME loans must therefore have robust relationships with conventional lenders. But this can be tricky: direct lenders will never know the borrower as well as the local bank that has provided its loans over the long term. Moreover, there are vast regulatory and cultural differences throughout the continent’s business landscape, which has hindered the pace of disintermediation in the European SME lending market. Here we highlight these differences:

Germany: A competitive, bank-dominated market served by many small regional lenders. These banks have a close understanding of their respective local regions, resulting in deep relationships with borrowers and consequently, numerous origination opportunities. Regulation is generally restrictive, but a new framework for lending by alternative investment funds was established in 2016, which has made it easier to enter the market.

France: A developed market, but it boasts fewer SMEs than Germany. The main barriers to entry include the country’s Napoleonic code of law, which is less creditor friendly than most Northern European jurisdictions, and the difficulty of originating good deals in a bank-led market. Lending is subject to a banking monopoly, and as such only certain entities are authorised to directly grant loans in France. Crucially for direct lenders, exclusive partnerships with French banks are difficult to execute, restricting deal flow.

Benelux: The Netherlands boasts good deal flow, a vast range of mid-market companies, and is considered a relatively open and developed market. Deal flow is weaker in Belgium, which has historically been a bank-led jurisdiction. Meanwhile, Luxembourg is the predominant fund domicile for the industry.

Nordics: The private debt market is at a nascent phase of growth, with little disintermediation.

Figure 1: Key differences in the European SME lending market

Source: Hermes Investment Management as at May 2018

Accessing European SME loans

In Europe, there are currently two distinct competing product segments in the SME lending market: senior-secured loans and unitranche loans. The senior-secured market is fiercely competitive as banks have generally improved their balance sheet capitalisations in recent years, enabling them to have strong lending appetites in this segment. We believe that they will continue to dominate the senior-secured market: they have proven track records, existing long-term relationships with borrowers and origination teams with a deep understanding of the local business environment.

For direct lenders, there are two ways to access the European SME senior-secured market:

Establish on-the-ground, geographically dispersed origination teams to foster relationships with debt advisors, private equity firms and regional banks. Challenged by the geographical scope of SMEs located across the continent, origination teams are unlikely to tap the entire suite of lending opportunities available in the region. As such, lending opportunities will be limited – typically to loan opportunities that banks have rejected. Direct lenders will therefore be unable to capture the most attractive opportunities available, unless they are willing to compete on loan terms and accept reduced lender protection rights.

Partner with local and regional banks by entering a non-exclusive or exclusive co-lending agreements.

Non-exclusive co-lending agreements: In these arrangements, local and regional banks disclose loans to direct lenders in order to plug funding gaps that they cannot cover. This means direct lenders see some – but not all – of a bank’s deal pipeline. For this reason, direct lenders with non-exclusive agreements will only see a bank’s refined deal pipeline on an ad hoc basis. A non-exclusive co-lending agreement, therefore, provides access to a limited number of opportunities. What’s more, many of these opportunities arise because the bank is unhappy about holding the majority of the loan on its balance sheet.

Exclusive co-lending agreements: Participating banks are legally obliged to disclose every deal they originate, within broad parameters, to direct lenders. That means the direct lender has visibility of the bank’s entire lending pipeline, and thereby has access to the best loans available. By entering an exclusive co-lending agreement, direct lenders gain the ability to choose the right loans and are therefore credit pickers rather than forced lenders – that is, those who are obliged to invest in a limited number of opportunities they see in order to meet deployment targets, irrespective of quality. Exclusive co-lending agreements, which are not commonplace in the investment landscape, mean that direct lenders and banks do not compete with each other. They ultimately result in a strong and unique origination strategy.

Figure 2: Accessing the European SME senior-secured market

Source: Hermes Investment Management as at May 2018

The different origination strategies used by direct lenders to access the European SME senior-secured market provide varying levels of deal flow. On-the-ground, geographically dispersed origination teams and non-exclusive co-lending agreements provide limited – and infrequent – access to SME loans. These deals are often second-tier transactions, which have already been refused by banks’ exclusive or favoured partners. Meanwhile, the exclusive co-lending agreements provides direct lenders with a rich pipeline of high-quality loans.

The Hermes approach

At Hermes, we have overcome regulatory and cultural challenges in Europe by establishing a set of exclusive co-lending agreements with four banks that have a broad geographic scope – namely, Royal Bank of Scotland (RBS), Danske Bank, DZ Bank and KBC Bank. These agreements give us access to the best deals to invest in on behalf of investors – our four partner banks are legally obliged to show us loan opportunities that they see in their regions.

What’s more, our partner banks have an extensive regional origination network across Europe, particularly in the UK, Germany, the Nordic countries and Benelux region. For example, DZ Bank’s standing as the second-largest bank in Germany serves to highlight its vast network at a regional level and our co-lending agreement means that we have first refusal of their vast suite of SME loans.

Our strong and unique origination strategy places us in a superior position to most other funds: we have access to a rich pipeline of high-quality loans, and thereby a portfolio with the potential to achieve stable, attractive returns.

Through our exclusive partnerships we examine about 700 loan opportunities each year – in comparison, our competitors view about 150 transactions over the same period. We therefore have access to loans – and regions – that other direct lenders do not. In other words, it allows us to be a true credit ‘picker’ rather than a credit ‘taker’. And this is reflected in our highly diversified portfolio of loans, which ensures low borrower concentration, thereby minimising default risk and losses.

This document does not constitute a solicitation or offer to any person to buy or sell any related securities or financial instruments.

1“Fund houses pile into direct lending as banks retreat”, published by the Financial Times on 6 March 2018